Too early to raise alarm over deflation
By Li Shi (China Daily)
Updated: 2005-03-10 06:32

The first month of the year has seen the consumer price index (CPI) fall to 1.9 per cent, a figure that has prompted some people to become alarmed about deflation.

Painful memories of deflation in the years after the 1997 Asian financial crisis are still too vivid to forget.

Some people have suggested that a further interest rate rise could worsen the situation and send China onto the track of economic stagnation.

It would be risky, however, for policy-makers to take the drop in the CPI in a single month as a barometer for measuring the whole economic picture.

The CPI's fall in January has been taken as a result of the interest rate hike implemented late last year. On October 28, the People's Bank of China, the country's central bank, announced that it was lifting its benchmark lending rate from 5.31 to 5.58 per cent.

In classic economic theory, interest rate hikes raise the cost of borrowing money and so dampen economic activity, which in turn affects prices.

Last October's interest rate hike certainly worked. It forced down the price index in January. A slight interest rate rise can have a big impact on prices, although there is always a time lag before monetary policies take effect.

Before the policy was hammered out, conservative economists had predicted an interest rate rise would not bring about the desired results since Chinese enterprises, many of which are State-owned, are not wholly market-oriented or duly interest-rate sensitive.

The current situation shows that monetary policy does have an effective role to play in directing market activities in the country, despite the immaturity of its market economy.

The temporary nature of the interest rate hike naturally leads to the question: Where will monetary policy go next?

In the wake of last October's rate increase, some economists claimed it was too little to stabilize the economy. But the CPI's fall in January - the rate was 3.9 per cent on average last year - seems to disapprove their argument.

But the change in the index does not mean policy-makers should preclude any interest rate manoeuvre in the coming months to fight "pending deflation."

Policy-makers initiated the interest move last October to pre-empt uncontrollable inflation. The aim is clear: Gradually achieve a soft-landing through modest interest rate adjustments. The 0.27 percentage point rise acted as a feeler to gauge market reaction.

More importantly, analysts point out, the central bank's move was just one link in an interest rate re-adjustment cycle. Central bank authorities have claimed there may be further tightening this year if over-investment cannot be curbed.

In this sense, a statistical change in a month is not enough information to prompt the government to re-direct its policies.

Technically, the CPI was low in January not only because last year's monetary policy has taken effect, but also because the Spring Festival, a major shopping season, was in January last year while this year's festival fell in February.

Considering this factor, February's CPI figure may rise significantly month-on-month. The Price Monitoring Centre of the National Development and Reform Commission has predicted the CPI could rise to over 3 per cent, and that the figure for the first quarter of this year could be around 2.5 per cent. Other think tanks believe the yearly CPI figure could be around 3 per cent.

In the coming months, it is certain that the CPI will recover from its January low. Deflation is not possible at the moment.

Moreover, the CPI calculation has not been updated for years. Its accuracy in mirroring the warmth of the economy has long been in doubt.

Many commodities that have a significant bearing on actual prices are not included in the CPI framework. Cars, travel, telecommunications and housing, all major items, are not taken into account in the CPI system.

House prices, for example, are soaring in China. Last year, the price of commercial land and housing rose by 10.1 and 9.7 per cent respectively. It is not realistic for us to expect this trend will not continue this year.

The question now seems to have shifted from whether policy-makers should take measures to prevent possible deflation to whether they will have to introduce interest rate rises to prevent inflation.

Despite the CPI drop in January, there still is a danger of inflation.

In the first place, the price of grain rose by 14.2 per cent in January. Grain is a vital commodity with strong price implications. Among last year's 3.9 per cent of CPI growth, 3.3 percentage points came from price rises of grain- and food-related products.

Prices of raw materials and fuel, the effect of which ultimately spills over into other fields, rose by 11.4 per cent last year. This trend will put great pressure on this year's overall price level.

For example, steel prices are set to rise this year following a more than 70 per cent iron ore price rise deal, reached between major Chinese steelmakers and a leading Brazilian mining company.

And oil, although it has dropped from last October's high, is expected to remain expensive.

Labour prices may follow suit. Since the Spring Festival, people have found migrant workers are in serious short supply in many places, which is driving up labour prices.

In the monetary policy report for the fourth quarter of last year, the central bank warned inflationary pressure has not yet ended.

At the ongoing National People's Congress session, policy-makers have also made it clear that macroeconomic measures will continue this year. This is a sign of doubt about the future of the economy.

According to a November survey by the central bank, 41.5 per cent of those surveyed thought consumer prices would rise further.

So, will there be deflation or inflation?

The answer may depend on economic data collected over a long period. The CPI figure for one month is not sufficient to provide a sound basis for ringing the deflation alarm bells.

(China Daily 03/10/2005 page4)

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